Co-op Bank Survival at Risk Following a Bad Case of Deal Indigestion

A deal struck over Chinese food in the summer of 2008 is creating some nasty after-effects for U.K. bank regulators and investors.

Co-operative Bank PLC on Thursday said bad loans, mainly from its 2009 merger with Britannia Building Society, wiped out a big chunk of its equity in the first half, putting its survival at risk. It wants junior bondholders to help fill a £1.5 billion ($2.3 billion) capital hole, and has given up on any aspirations of becoming a major force in British banking after a failed effort to buy 632 branches from Lloyds Banking Group PLC.

A new management team, under former HSBC North America CEO Niall Booker, say they want to look forward, not back, but the burning question continues to be: how did things go so wrong for Co-op?

The short answer is Britannia. Mr. Booker on Thursday said the bulk of £496 million in first-half impairments came from commercial property loans made by Britannia. Mortgage loans from the building society’s “Optimum” subprime book are also producing losses, he said.

The longer answer to the question, now being sought by a Co-op commissioned independent review, will center on who knew what when about Britannia’s troublesome assets, and why it took so long for Co-op Bank to recognize their diminishing value. The bank said Thursday it has changed the way it assesses likely losses.

The merger with Britannia was conceived by David Anderson, then the head of Co-op Bank, and Neville Richardson, Britannia’s CEO who went on to lead the combined bank until 2011. Mr. Richardson told the Observer newspaper in 2009 that the outline of a deal was formed over crispy duck at a restaurant in an affluent suburb of Manchester.

The idea was to create a £70 billion “super mutual” that could take on the likes of Barclays and Royal Bank of Scotland. Mr. Richardson and Mr. Anderson touted the combined group as an alternative to high-street banks, at a time when customers’ confidence in banks had plummeted.

Co-op was advised on the merger by J.P. Morgan Cazenove and Britannia was advised by Citigroup.

Spokeswomen for J.P. Morgan Cazenove and Citigroup declined to comment today. A representative for Mr. Richardson didn’t immediately respond to requests for comment Thursday and Mr. Anderson couldn’t be reached.

Co-op executives on Thursday said the independent review of Co-op Bank’s problems should be completed by May. A parliamentary committee is separately looking at why the bank was able to proceed with a bid for the Lloyds branches even as its financial strength was deteriorating.

The Treasury Committee said Thursday that it will question Mr. Richardson next week on Co-op’s failed bid for the Lloyds branches.